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Unprecedented market volatility could lead to stagflation, but don't expect a 'Poloz put'

Governor of the Bank of Canada Stephen Poloz.Photo: Justin Tang / Canadian Press

Victor Ferreira

Published: December 6, 2018 - 5:39 PM

As North American markets continued on their downward trajectory on the heels of Huawei chief financial officer Meng Wanzhou being arrested in Canada, Bank of Canada governor Stephen Poloz warned that what the dominant risk markets are wrestling with is the flurry of news.

Poloz was in Toronto on Thursday morning, where he delivered his final planned speech of the year, addressing the instability of the markets and the declining performance of the oil sector one day after the central bank decided to maintain the interest rate at 1.75 per cent.

By the time Poloz had finished with his prepared remarks, the markets had opened and cratered. Skittish investors, fearing an escalation in the U.S.-China trade war once again, abandoned the equities market after Canadian authorities arrested Meng, a Chinese national who is sought for extradition by the U.S.

The S&P Toronto Stock Exchange Index dropped 1.6 per cent, closing 245 points down. The Dow Industrial Average, meanwhile, lost more than 785 points in early trading, after dropping 800 in its previous session on Tuesday, but rallied near the end of the day to close 79 points down.

A recalibration of the market was always expected, Poloz said, as rising interest rates placed the risk back into the market and off the balance sheets of the central banks. The added volatility from the trade war, however, is unprecedented, he said, especially when one tweet from U.S. President Donald Trump can send markets into a tailspin.

“To move up and down on the basis of a tweet … that’s volatility I haven’t seen before,” Poloz said at press conference after his speech. “In fact it is a highly uncertain thing and it’s like a lights off, lights on kind of risk.”

The Bank of Canada governor said he’s developed the habit of spending his mornings staring at screens and trying to understand everything that doesn’t appear to make sense about the current market situation. While Poloz hasn’t seen this level of volatility before, he can predict that it may lead to stagflation.

A global slowdown was already being projected, he said, and that’s needed to cooloverheating economies, but tariffs could worsen the problem. Tariffs not only increase economic slowdown, he said, but raise inflation risks.

The resulting stagflation is challenging for central banks because a slowing economy is usually dealt with by lowering rates, but inflation risk is handled by raising them.

“It’s a very undesirable outcome,” he said. “It’s not good for anyone. I can understand markets being preoccupied with that risk.”

Even with the risks involved, that doesn’t mean Poloz is prepared to act aggressively to combat them. There will be no “Poloz put” he said, refusing to give investors assurances that he’ll lower or maintain interest rates to support markets. Although the central bank did not alter them, Poloz said he intends to hike them in the future to a neutral range, which he said is somewhere between 2.5 and 3.5 per cent.

… let’s all knock on wood right now

Bank of Canada Governor Stephen Poloz

Poloz is hoping for a solution to play out in the similar way to the U.S.-Canada-Mexico trade negotiations. Investors can assume the worst, but it was only three months ago when “many, many people were totally convinced that NAFTA would be torn up, and an agreement was reached,” he said.

The U.S. and China showed positive signs in negotiations after Trump and China President Xi Jinping met at the G20 summit in Argentina last weekend. Investors swooned on Monday and the markets rallied as Trump announced that Xi would cut auto tariffs on American cars. A day later, Trump admitted in a tweet that the two sides were negotiating a “real deal” before souring market sentiment with a warning that he’s “the Tariff Man.”

As the markets continue to show extreme sensitivity to the trade war, that leads to further uncertainty for investors in the future, Poloz said.

“Today, it’s got to do with, again, the China and U.S. relationship and where does that all take us, so let’s all knock on wood right now,” Poloz said, pausing before softly striking his wooden podium.